Oil Price Spike Update

On July 8th, 2011 we wrote a post entitled why Oil Price Spikes Feel Worse wherein we stated that "Today, more now than ever, we are barraged with economic data of which most is lost on the average person. One data point, however, that everyone understands is the price of oil as it directly impacts the average American where it counts the most, in the wallet. The price of oil cannot be escaped as it is plastered just about everywhere these days whether it is the current Administration admonishing oil and gas drilling companies, headlines in newspapers or on the internet and, ultimately, you see it at the gas pump. Oil prices affect us every day in more ways than just what we are paying for gasoline, of course, it also affects everything that wear, consume or utilize from hard products to services due to rising input costs, fuel surcharges, etc."

This has become more prevalent lately due to the decline in real personal incomes and the rising cost of food and energy which is consuming more of those incomes in percentage terms. As we stated in our recent report on 3rd Quarter GDP: "When food and energy are already consuming more than 23% of wages and salaries; things are tough."

This is one reason that when the government reports the consumer price index (CPI), and then strips out food and energy to report core inflation, it almost always elicits a negative response. This was evidenced by the response to Fed President William Dudley who got a street-comer education in the cost of living. Back in March, on a Fed Reserve campaign to sell its monetary policy to "average Americans"; Dudley tried to explain that while commodity prices are rising other prices are falling.

"Today you can buy an iPad2 that costs the same as an iPad 1 that is twice as powerful, you have to look at the prices of all things."

The reason that the "average American" can't grasp things like "hedonic"adjustments to the inflation index, or even the idea of stripping out volatile food and energy components of CPI to get a core index, is because they live in a world where their daily lives are fixed to the disposable personal income they bring home. The average American gets a paycheck and then has to buy gas and food, pay rent and insurance, buy clothing, and pay for utilities. This is why Bill Dudley was immediately lambasted by the reporters in the audience following his iPad statement with; "I can't eat an iPad" and "When was the last time YOU went to a grocery store?"

While there has been a lot of pandering about high oil prices, and ultimately high gasoline prices, what is more important to note is how do these price increases in oil "feel" to the average American. The thing that the Fed misses, in my opinion, is that the average "American" is dealing with a lot rising cost pressures that aren't necessarily included in the inflation calculation. Furthermore, while prices of things like oil, commodities, college costs, insurance, healthcare, etc. have been rising; disposable personal incomes have been falling. Therefore, each price increase that occurs has a larger and larger net effect on the limited amount of disposable personal incomes available to the consumer.

This is why most consumer polls show that consumers "feel" like we are still in a recession. To those individuals a recession is equivalent to not being able to make ends meet at home. When the consumer is under pressure at home they tend to buckle down and reduce consumption. This is specifically why we are seeing such a lack of final demand from the consumer on small businesses. This in turn is keeping them entrenched in a defensive position by not hiring workers or expanding production.

The first chart above shows inflation adjusted oil prices over inflation adjusted disposable personal income and oil prices. Since oil prices are a direct input cost into so many different aspects of the daily lives of the average "American"; price spikes in oil have a very real impact on the way that consumers "feel" about their ability to make ends meet.

What we find is that when oil prices spike there is an immediate shock to the disposable personal incomes for individuals. For example, during the Iran crisis oil peaked at $110 per barrel for consumers, however, it "felt" like $229 a barrel. Then at the peak of the oil market in 2008 when oil traded for $140 a barrel it felt much closer to $253 as real disposable incomes had declined. In July, when I last penned this update oil traded at $96 a barrel as it does today. The difference at that time was that it "felt" like it was closer to $119 versus $103 today.

This psychological "cost pressure" obviously impacts the way that consumers behave with their money. While the government tries to massage the differences in inflationary pressures to suppress adjustments to Social Security and Medicare; the average American is rapidly coming to grips that there is something entirely wrong with the state of affairs in the U.S. economy. At some point the process of kicking the can down the road will meet its inevitable conclusion in this game of chicken as the process of deleveraging continues.

Furthermore, with the economy already weak, this is poor timing for oil prices to be surging higher from below $80 this summer to $96 currently. That 20%+ increase in costs will begin to crimp already weak consumer spending as we head into the very "hopeful" holiday shopping season. The economy is a long way from being out the woods and the impact of rising oil prices, when overlaid with declining incomes, just doesn't "feel" like it is going to be a good thing.

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of "Street Talk with Lance Roberts", Chief Editor of "The X-Factor" Investment Newsletter and the Streettalklive daily blog. Follow Lance on Facebook, Twitter and Linked-In